Norton Rose Fulbright: Mexico’s Realization of a Re-Energized Industry

Norton Rose Fulbright: Mexico’s Realization of a Re-Energized Industry

By Lauren Brogdon, Tessa Cabello ;and Ariel Cue

In late December 2013, the Mexican government, under President Peña Nieto, promulgated a Decree (the "Decree") amending the Political Constitution of the United Mexican States (the "Constitution") that introduces new opportunities for private investment in the oil, gas and refined products industries that have been under monopolistic control by the state-owned company, Petróleos Mexicanos ("PEMEX"), since 1938.  Among many objectives (including reforms affecting the midstream, downstream and electric power sectors), the Decree amends Articles 25, 27 and 28 of the Constitution (along with 21 Transitional Provisions), transforming the way in which the Mexican government approaches private investments in the upstream energy industry, while still expressly reserving ownership of the hydrocarbons in place to the State – a historically important symbol of national pride.  While many details of the reform will not be clarified until the secondary, implementing legislation is passed by Congress over the next few months, the amendments to the Constitution are expected to invigorate the oil and gas industry in Mexico by enabling meaningful foreign and domestic private investments and participation.

Historical development of Mexico's energy industry

The Constitutional amendments mark a drastic departure from the nationalism and protectionism that have characterized the Mexican energy industry throughout its long history.   In 1917, shortly after the 1911 Mexican revolution and under the administration of President Venustiano Carranza, the adoption of Articles 27 and 28 of the Constitution restricted the participation of private companies in the energy sector and transformed the country's energy sector from what was previously a liberal concession regime.  Those Constitutional provisions established Mexico's direct ownership over natural resources and exclusive right to explore and exploit hydrocarbons, and determined that electricity and hydrocarbons, among other areas, were to be considered strategic areas under the State's monopoly. The 20-year transitional period that followed was marked by conflicts between energy companies and the Mexican government with respect to the interpretation and application of the Constitutional provisions, the Government's attempts to impose a concession regime in areas previously owned by foreign oil companies, and the assessment of new taxes, which culminated in a full expropriation of foreign and US assets in 1938 under Lázaro Cárdenas' presidency.

From 1938 to 1958, the Mexican government took increasingly nationalist measures to gain complete control over the oil and gas industry, creating PEMEX and subsequently enacting the Petroleum Law of 1958 to implement Article 27 of the Constitution after it had been only selectively enforced for decades. The Petroleum Law of 1958 effectively shut the doors to risk-service contract agreements. The only channel available for private sector involvement in oil and gas contracts was a service contract providing for remuneration in cash only; no compensation to private companies could be based on participation or production. Not surprisingly, PEMEX found it difficult to attract foreign investors under this scheme, causing a period of struggle until the mid-1970s, when it made some substantial discoveries in the Reforma and Cantarell oil fields. For some 20 years thereafter, Mexico's oil and gas sector managed to sustain itself based from revenues stemming from exploitation of those two fields and foreign exportation of crude oil.

By 2008, PEMEX had been operating at a loss for several years due to the increased depletion of the Reforma and Cantarell fields, lack of capital to invest in exploration of new fields, a growing tax burden, and outdated, nonfunctional corporate governance policies.  Aware of these issues, President Felipe Calderón proposed the 2008 Energy Reform. Like Nieto, Calderón originally sought a liberalization of the petroleum industry to private sector participation, but the unfavorable political environment at the time led him to soften his proposal. As implemented, the 2008 reform offered more autonomy and flexibility to PEMEX and introduced important regulatory, environmental, and corporate governance changes in the company.  Although far from a full liberalization, Calderón's reform may have planted the seeds for the current reforms and, most importantly, signaled an increasing public dissatisfaction with the status quo in Mexican energy that likely led to the issuance of the Nieto administration's Decree in December 2013.

Transition to a more cooperative scheme 

The Transitional Provision Ten of the Decree sets out that Mexico's Secretary of Energy ("SENER") will be responsible for managing Mexico's oil and gas reserves and identifying areas of interest for exploration and production, with the technical assistance of the National Hydrocarbons Commission ("CNH").  CNH is the body that will award contract entitlements.  SENER, CNH and the Ministry of Finance will collaborate on the determination of acceptable percentages to be paid to operators, the revenues on the hydrocarbons sold and the license fees applicable for license agreements. 

Following the effective date of the Decree, PEMEX has a 90-day window to identify to SENER the oil and gas fields PEMEX has been exploring or producing that PEMEX believes it has the financial and technical capability to continue to operate efficiently and commercially, which are being referred to as "round zero" applications.  SENER, with the technical assistance of CNH, will review PEMEX's applications and issue its determination of PEMEX's "round zero" lease allocation after 180 days of the submitted applications.

After the "round zero" application and assessment period has ended, SENER and CNH will determine which areas will be made available to private parties.  CNH shall conduct a bid round according to the terms established by the implementing legislation and will evaluate and select the winning bidders.  At a minimum, the Transitional Provision Six provides that SENER shall establish the technical and contractual guidelines for such bid rounds, and the Secretary of the Treasury shall establish the financial terms and conditions.  At this time, the Transitional Provisions do not make the specific steps of the bid rounds clear.  For example, it is not known whether CNH will have the discretion to choose a private contractor that has superior or proven technological capabilities but may not be the highest bidder.  Equally, it is not apparent from the Transitional Provisions whether such bid rounds will include the ability to enter into individual negotiations with certain parties, or whether it will entail a competitive bidding process or a tender process.  What is clear, however, is that the implementing legislation shall provide for and regulate the contracts the State enters into with respect to the exploration and production of hydrocarbons, including a requirement that such contracts have "transparency" clauses that will allow any interested party to review them, including possible disclosure of the consideration, contribution and payments provided for in such contracts.

The ‘menu’ of potential contracting frameworks available under the decree

The guiding principle in the Constitutional amendments is to "maximize[e] the Nation's revenues, in order to achieve the greatest benefit for long-term development."  With this maxim in mind, the law expressly provides for the following "menu" of types of consideration and agreements that are available for use in contracting with private parties for exploration and production of Mexico's hydrocarbons: (i) in cash, for service contracts; (ii) a percentage of profit, for profit sharing contracts; (iii) a percentage of the production, for production sharing contracts; and (iv) transfer for consideration of hydrocarbons once extracted from the subsoil, for license contracts; and (v) any combination of the foregoing.  While the Transitional Provisions state that these referenced contractual arrangements will be provided for in the forthcoming implementing legislation, the Transitional Provisions also seem to suggest that other types of consideration and contract forms might be permitted.

The risk profile of the exploration and production project will likely influence the choice among the four types of agreements in the CNH's arsenal of tools.  Attracting international companies with experience in deepwater exploration will most likely be a focus of the government, as Mexico has previously lacked the technical capabilities to effectively explore or produce in deepwater areas in the Gulf of Mexico.  Additionally, development in unconventional formations is thought to be another possible area of interest for attracting private investment, particularly given the proximity to the United States-Mexico border of one of the fastest growing shale producing areas in the United States, the Eagle Ford basin in Texas,.  Below is a high-level, brief description of the common principles or typical hallmarks of the above-listed agreements, though the specific forms and details of these types of agreements will be elucidated in the forthcoming secondary legislation in Mexico, which may vary from what is described below.

Service contracts refer to a type of contractual framework in which the company retained as the service provider performs a set of activities on behalf of the host country (or its nationalized entity) in exchange for consideration.  The contracting service provider is not a partner or a holder of any right to the production, but rather a hired agent.  In the most basic form of a service contract, the service provider has no upside to the contractual arrangement, and the host country (or its nationalized entity) retains all the upside.

Profit sharing agreements may take many forms, including an analogous structure to the production sharing agreement (described in greater detail below), except that the private company will receive a percentage of remaining revenue instead of production.  Profit sharing agreements may also refer to an arrangement in which the private party and the host country (or its nationalized entity) will enter into a participation agreement to establish a joint venture company.  In this instance, the private party may bear the expense and costs during the exploration phase, and following a commercial discovery, the host country (or its nationalized entity) and the private party involved will share the expenses of production, and the private party will be entitled to a portion of the revenue while the host country will retain title and ownership to the production and any equipment associated with the production.

The basic principle of a production sharing agreement is that the host country owns all the hydrocarbons in the area and enters into an agreement permitting a private company the exclusive right to explore for and produce petroleum for a fixed term.  In return, the contracting company receives a share of the petroleum production.  Further complexities in the agreement may change the ratio of production the contractor is entitled to over the life of the agreement.  The contractor may also be entitled to claim all or a portion of its operating and exploration costs (including depreciation of capital costs and production) from the production.  After the contractor has recovered the investment costs it is entitled to recoup, the remaining quantity of petroleum produced may be shared according to a production sharing formula that might be fixed or on a sliding scale.  The production sharing agreement does not allow the contractor to continue to have an exclusive right to explore and produce the entire allotted acreage for the term of the agreement; typically, after an agreement is entered into, the contractor will have a certain number of years by which a commercial discovery of petroleum must be made, subject to extensions granted by the host country.  Additionally, the production sharing agreement will usually provide for a progressive pattern of relinquishment of acreage by the contractor during the life of the agreement and may also permit the contractor to voluntarily surrender acreage under certain circumstances.  The production sharing agreement will also require the contractor to comply with a work program and minimum expenditures for certain exploration activities, such as seismic surveys and exploratory wells to be drilled.  The risk of unsuccessful exploration operations is therefore borne by the private party and no recoupment of expenses or revenue will be received by the contractor until production is achieved, if at all.

License agreements refer to a broad range of contractual arrangements, and the secondary legislation should clarify what kind of framework the government intends to achieve with such a contract.  The United States Congressional Research Service in a January 6, 2014 report states that a license will enable a company to obtain ownership of the oil or gas at the wellhead after it has paid applicable taxes, and the Transitional Provision Four appears to accommodate this view, though it will not be clear what type of agreement is intended here until secondary legislation is implemented.

In addition to the contractual framework available to parties conducting exploration and production activities that the Transitional Provision Four mentions expressly, there may be others that are introduced in the implementing legislation.

The effect on deepwater exploration and development

The Constitutional amendments will also affect the exploration and development of deepwater resources in the Gulf of Mexico.  In 1997, the US and Mexico demarcated boundaries with respect to the continental shelf in the Gulf of Mexico.  In 2001, the countries ratified the "Western Gap Treaty," setting the rights and duties regarding possible transboundary hydrocarbon reservoirs, creating a buffer zone around the 1997 boundary, and establishing a ten-year moratorium on the exploitation of resources near the US-Mexico boundary line.  Although it was not definitively known then (and remains to be seen now) whether transboundary hydrocarbon reservoirs even exist in the boundary area, the Western Gap Treaty effectively precluded either the US or Mexico from confirming the existence of any transboundary reserves. 

In 2012, the US and Mexico signed the US-Mexico Transboundary Hydrocarbons Agreement ("Transboundary Agreement"), which lifted the moratorium on exploration and production in the buffer zone and created options for the joint development of transboundary hydrocarbon reservoirs that straddle the marine border between the US and Mexico in the Gulf of Mexico.  In October 2013, the US Senate passed a bill to allow the Secretary of the Interior to implement the Transboundary Agreement.  Coupled with the amendment to Article 27 of the Constitution, meaningful US-Mexico joint development in the Gulf of Mexico is now a possibility.  Since cooperative schemes are no longer constitutionally prohibited, the reforms will open the door to allow PEMEX and foreign energy companies to work together to minimize costs, maximize profits, prevent resource waste, and increase efficiency in exploration and development of hydrocarbon resources.

It is uncertain whether foreign companies will have sufficient incentives to partner with PEMEX on transboundary development, since Mexico lacks significant deepwater experience to date, and foregoing complicated agreements in lieu of the rule of capture is a much simpler alternative.  And as with the contractual frameworks now permitted by the Constitutional amendments, it also remains to be seen how the Transboundary Agreement will be implemented in areas in which the ban on exploration and development of hydrocarbon reservoirs had been in place. 

Conclusion

While the amendments to the Constitution achieve a groundbreaking shift in Mexico's approach to private investment in developing the country's resources, the international oil and gas industry eagerly awaits the detailed terms of how this new approach will be implemented.  While drafting the implementing legislation, if the legislating bodies in Mexico continue to keep in mind the guiding principle of "maximizing revenues, in order to achieve the greatest benefit for long-term development," the Mexican energy reforms may achieve far-reaching impact on economic growth in Mexico, beginning first with an infusion of private investment that will hopefully boost oil and gas production, lower the cost of energy and create new jobs in Mexico.

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